OREANDA-NEWS. S&P Global Ratings said today that it affirmed its 'BBB' long-term corporate credit rating on U. K. water company Dee Valley Water PLC (DVW). The outlook is stable.

At the same time, we affirmed our 'BBB' issue ratings on the senior secured debt and revolving credit facility (RCF) issued by Dee Valley Water.

Our affirmation reflects DVW's consistent and predictable revenue and cash flow streams from the low-risk, regulated water business, as well as its natural monopoly position and a generally supportive and transparent regulatory framework. It also reflects our view that DVW's substantially improved operating efficiency is offset by our forecast of continued significant negative discretionary cash flow (DCF).

We assess that the U. K. water regulator Ofwat and its framework offer DVW a strong regulatory advantage. The framework has a long track record of over 20 years with transparent guidelines, good and timely recovery of costs (albeit on an ex-ante basis), high predictability and consistency, and regulatory independence. Like all U. K. water companies, Dee Valley Water is exposed to regulatory reset risk every five years, as well as sector reforms proposed by the regulator and the government. Reset risk is low at the moment as the current regulatory period commenced in April 2015.

There has been a substantial ongoing improvement in DVW's operating efficiency, leading us to revise our assessment of its business risk profile to excellent from strong. DVW has demonstrated improved regulatory key performance indicators (KPIs) over the past few years, and has moved from having one of the lowest Service Incentive Mechanism (SIM) scores among water companies to achieving fourth place during the last financial year 2015/2016. Historically, DVW failed to meet Ofwat's standards for asset serviceability due to discolored water caused by high levels of manganese at its key water source, but the company has significantly reduced customer complaints following the replacement of key assets and significant cleaning program. We expect DVW to use substantial capital expenditure (capex) on the decommissioning of the Legacy treatment plant to treat the discolored water. This necessitates the construction of additional pumping storage and improving connectivity within the network and between adjacent water companies.

We project that DCF will remain on average about -7% in the next two-to-three years due to the large capital investments required to meet regulatory KPIs. As a result, we have revised our assessment of DVW's financial risk profile downward to aggressive from significant. In our view, the negative DCF constrains DVW's ability to absorb operational and financial shocks. However, we expect the company's S&P Global Ratings-adjusted ratio of funds from operations (FFO) to debt to remain at the high end of the range commensurate with the significant financial risk category, averaging 12.0% over the two-year rating horizon. We use our low-volatility financial benchmarks for DVW as the company derives all of its earnings under a regulatory regime that we view as low risk.

A change in inflation--the retail prices index (RPI), the consumer prices index (CPI), or CPIH (which includes owner occupiers' housing costs)--could affect small companies like DVW that have a high proportion of long-dated, RPI-linked debt. This could leave DVW exposed to a mismatch in revenues and actual financing costs (see "Ofwat Water 2020: Rising Volatility And Decreasing Earnings Could Pressure Ratings On U. K. Water Utilities," published on June 23, 2016).

Our base case assumes:

U. K. RPI inflation of 1.8% in 2016, 3.0% in 2017, and 2.5% in 2018.Mid-single-digit percentage revenue growth from 2017. Stable EBITDA margins of about 45%-50%. Dividends of about ?2.9 million and remaining flat over the regulatory period. Capex of about ?35 million for the rest of the regulatory period. The Legacy treatment works on track to outperform on costs against allowances for the current regulatory period. Tariff assumptions as per the regulatory allowance, which is set until 2020. Based on these assumptions, we arrive at the following credit measures:

FFO to debt of about 11%-13% over the next three years. DCF to debt of about -8.0% on average over the next three years. The stable outlook reflects our expectation that DVW will post negative DCF on average due to the sizable capex plan and maintain FFO to debt above 9% for the next two-to-three years. It also reflects our expectation that there will be no deterioration in its operating and regulatory performance.

We could consider lowering the rating if DVW is unable to maintain adjusted FFO to debt of at least 9%. This could be caused by, among other factors, operating cost overruns or an inability to recover unexpected costs through the regulatory framework. We might also consider lowering the rating if regulatory measures of the company's operating performance deteriorate.

Conversely, we could raise the rating if DVW's cash flow protection metrics and financial risk profile improve significantly on a sustainable basis. Specifically, we could raise the rating if DVW's DCF is set to return to neutral levels thanks to the successful completion of the company's large capex plan and FFO to debt remains sustainably above 12%. We could also raise the rating if DVW's shareholders define a clear financial policy.